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Leveraged buy outs

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Leveraged Buy Outs

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LBO-Definition <ul><li>It involves the use of a large amount of debt to purchase a firm. </li></ul><ul><li>LBOs are clear-cut example of a financial merger undertaken to create a high-debt private corporation with improved cash flows and value. </li></ul><ul><li>Typically, in an LBO, 80% or more of the purchase price is financed with debt. </li></ul><ul><li>A large part of the borrowing is secured by the acquired firm’s assets. </li></ul>

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Features of an LBO Candidate <ul><li>An attractive candidate for acquisition via LBO should possess the following attributes: </li></ul><ul><ul><li>It must have a good position in the industry with sound profit history. </li></ul></ul><ul><ul><li>It should have a relatively low level of debt and high level of “bankable” assets. </li></ul></ul><ul><ul><li>It must have stable and predictable cash flows that are adequate to meet interest and principal payments on the debt and provide adequate working capital. </li></ul></ul>

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Leveraged Buy-Outs Unique Features of LBOs Large portion of buy-out financed by debt Shares of the LBO no longer traded on the open market

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Advantage Tata <ul><li>The acquisition helps Tata reach the fifth position from 56 th in global steel production capacity. </li></ul><ul><li>With the exception of Arcelor Mittal, which has a combined production capacity of 110 mtpa, Tata Corus, with a capacity of 23.5 mtpa, will be only 5-7 mtpa shy of the next three players-Nippon Steel, Posco, and JFE Steel. </li></ul><ul><li>Globally top 5 players will now control only about 25% of global capacities. </li></ul><ul><li>Tata Steel gets access to European market and significantly higher value-added presence. </li></ul>

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Cost of the Acquisition <ul><li>Tata proposed to pay a price of 608 pence a share from 455 pence initially. CSN bid 603 pence. </li></ul><ul><li>This translates to $12.1 billion in equity value and with a debt component of around $1.5 billion, the enterprise value of Corus is $13.6 billion. This is 34% higher than the initial offer (455 pence) the Tatas made. </li></ul>

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Financing the Acquisition <ul><li>The acquisition would be funded through a debt-equity ratio of 53:47 (initially it was 78:22) </li></ul><ul><li>The exposure of Tata Steel was initially thought to be in the region of $4.1 billion which will be a mix of debt and equity. </li></ul><ul><li>The rest of the funding, through long term loans, will be done by the special investment vehicle created in UK for this purpose. </li></ul><ul><li>Such loan will be serviced out of Corus’s cash flows. </li></ul>

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Financing the Acquisition <ul><li>Tatas could raise the equity component in the form of preferential offer by Tata Steel to Tata Sons, or through GDR or rights offer to shareholders. </li></ul>

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Expected Synergies <ul><li>In the third quarter ended September 2006, Corus had clocked an operating margin of 9.2% compared to 32% by Tata Steel for the third quarter ended December 2006. </li></ul><ul><li>Synergies are expected in the procurement of materials, in the market place, in shared services, and operational efficiencies. </li></ul><ul><li>Potential synergy value is $300-350 million a year </li></ul>

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Valuation of LBOs: The APV Method <ul><li>The APV method captures values from investment and financing decisions separately </li></ul><ul><li>􀂄 Two primary decisions in a corporation </li></ul><ul><ul><li>􀂉 Investment & Financing </li></ul></ul><ul><li>􀂄 The APV method measures value from these two separately </li></ul><ul><li>􀂄 Before studying APV, important to understand the effect of financing decisions on firm value </li></ul>

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The APV Formula so far <ul><li>The contribution of debt to firm value is the PV of tax shields </li></ul><ul><ul><li>V(levered firm) = V(all equity counterpart) + PV(tax shield) </li></ul></ul><ul><li>Each part is discounted based on its risk </li></ul><ul><li>The V(all equity) captures solely the risk of operations of the firm. It is unaffected by financing risk. Hence use β A </li></ul><ul><li>The tax shields can be discounted at either of two rates </li></ul><ul><ul><li>If tax shields are as risky as the cash flows to the all-equity firm, use β A . Appropriate for higher debt levels. </li></ul></ul><ul><ul><li>If tax shields are as risky as the debt, use cost of debt. Appropriate for low and known debt levels. </li></ul></ul><ul><li>If D is face value of debt, interest payment = rD * D </li></ul><ul><li>Tax shield = tC * Interest payment = tC * rD * D </li></ul><ul><li>Using perpetuity formula PVTS = (tC * rD * D) / rD = tC * D </li></ul>

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The Dark Side of Debt is the Expected Cost of Financial Distress <ul><li>If taxes were the only issue, (most) companies would be 100% debt financed. </li></ul><ul><li>Debt would have only tax benefits but no costs </li></ul><ul><ul><li>Common sense suggests otherwise </li></ul></ul><ul><ul><li>Debt must have costs as well </li></ul></ul><ul><li>If the debt burden is too high, the company will have trouble paying it. </li></ul><ul><li>The result: financial distress . </li></ul>

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APV vs. WACC 􀂄 Use WACC when the project’s debt to equity ratio is known 􀂄 Use APV when the project’s level of debt is known 􀂉 Appropriate for Leveraged Buy Out or High Leverage Transactions 􀂉 Also appropriate to see value separately from financing and operations.